Climate Change and Investment Decisions: Selected Reading

That climate change is an irreversible threat was the key premise underlying the COP21 deal reached among almost 200 nations in Paris this week. But while climate change routinely makes headlines around the world, curiously there is little if any coverage of the phenomenon in traditional investment textbooks.

So how can institutional investors integrate climate change into their investment decisions? It’s a challenging question certainly, and some would expect it to remain unanswered — or relegated to obscure academic papers. On the contrary, it is a question that is being addressed head on by investment practitioners. Here is a list of five publications from 2015 that directly take on the challenge of climate change and investing.

This discussion paper produced by the Principles for Responsible Investment (PRI) Climate Change Strategy Project lays out a strong case for asset owner action, highlights the key factors to consider when setting an emissions reduction goal, and explains how measuring a carbon footprint can assist in reducing emissions. PRI has 1380 signatories with $59 trillion of AUM and the perspectives presented in the report are especially relevant to asset owners.

The paper explains the key factors asset owners should consider:

“Response to climate change must be tailored to an asset owner’s investment approach and asset class mix. This could involve: measuring a portfolio carbon footprint; engaging with policy makers and companies on transitioning to a low-carbon economy; and accelerating newer forms of investment. For some asset owners, divestment will be part of a risk management strategy or a way to align investment beliefs and values, while many organisations are finding that alternatives to divestment, such as engagement and reinvestment into low-carbon initiatives are effective.”

Published by the CDP (formerly Carbon Disclosure Project), this report offers “a global analysis of the current state of the corporate response to climate change.” The CDP has 822 signatories with US$95 trillion in assets and thus its analysis has considerable relevance for investors.

As the report puts it:

“Those investors who understand the need to decarbonize the global economy are watching particularly closely for evidence that the companies in which they invest are positioned to transition away from fossil fuel dependency. By requesting that companies disclose through CDP, these investors have helped create the world’s most comprehensive corporate environmental dataset. This data helps guide businesses, investors and governments to make better-informed decisions to address climate challenges.”

The report is not particularly lengthy, though it lacks both an executive summary and conclusion.

This 10-page report by Standard & Poor’s Rating Services explores the potential impact of such natural catastrophes as earthquakes, tsunamis, storms, droughts, and floods on the credit ratings of companies in various sectors. The title gives a clear indication of the content coverage. The key takeaways are identified as follows:

“However, the more frequent and extreme climatic events many scientists predict could adversely affect companies’ credit profiles in the future.

“Greater disclosure of firms’ exposure to extreme natural catastrophes should, in our opinion, encourage them to bolster their resilience to these events and thereby aid transparency.”

The report goes on to state that:

“No sector is immune to the effects of natural catastrophes. However, the energy sector (through a direct impact on production and distribution facilities and market dislocation) and the consumer products sector (through supply chain and market disruptions) appear most exposed.”

This analysis by the consulting firm Mercer frames climate change as a source of risks and opportunities for investors.

“Climate change is an environmental, social and economic risk, expected to have its greatest impact in the long term. But to address it, and avoid dangerous temperature increases, change is needed now. Investors cannot therefore assume that economic growth will continue to be heavily reliant on an energy sector powered predominantly by fossil fuels. This presents asset owners and investment managers with both risks and opportunities.”

The questions it attempts to answer through scenario analysis are:

“How big a risk/return impact could climate change have on a portfolio, and when might that happen?

“What are the key downside risks and upside opportunities, and how do we manage these considerations to fit within the current investment process?

“What plan of action can ensure an investor is best positioned for resilience to climate change?”

At over 100 pages, the report is a relatively long read. But fortunately it does include a brief executive summary. It is available free of charge, though a short registration process may be required before it can be downloaded.

This report was commissioned by the Investment Leaders Group and the University of Cambridge Institute for Sustainability Leadership. An interesting point that it makes early on is that investors won’t have to wait until the worst of climate change’s toll is felt. This is because as the adverse impact becomes increasingly obvious, financial markets will react to the anticipated catastrophes.

“This research shows that changing asset allocations among various asset classes and regions, combined with investing in sectors exhibiting low climate risk, can offset only half of the negative impacts on financial portfolios brought about by climate change. Climate change thus entails ‘unhedgeable risk’ for investment portfolios.”

Like the Mercer report, it also relies on scenario analysis.

Other Publications

Other 2015 publications on climate change and investing suitable for institutional investors include:

There has been a distinguishable growth spurt in the body of knowledge about climate change and investing. Going through these reports, it is clear that the underlying question — “How does climate change relate to investment decisions?” — is being addressed with increasing specificity. Now it is up to those asking the questions to pay heed to the answers.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Usman Hayat writes about sustainable, responsible, and impact investing and Islamic finance. He is the lead author of "Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals," and the literature review, "Islamic Finance: Ethics, Concepts, Practice." He is interested in online learning and has directed three e-courses for CFA Institute: "ESG-100," "Islamic Finance Quiz," and "Residual Income Equity Valuation." The other topics he writes about are macroeconomics and behavioral finance. Previously, he was a content director at CFA Institute. He is a former executive director at the Securities and Exchange Commission of Pakistan (SECP). He has experience working in securities regulation and as an independent consultant. His qualifications include the CFA charter, the FRM designation, an MBA, and an MA in Development Economics. His personal interests are reading and hiking.

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